On Price Distortions and Landmines

Former Federal Reserve Chairman Alan Greenspan told CNBC on Friday that the Dow’s new highs and 10-day run were not the result of “irrational exuberance.” On cue, the Dow took a 25 point nose dive…closing out the day with its first loss since March 1.

If you recall, during the early part of the stock market bubble up period of the late 1990s, Alan Greenspan asked if irrational exuberance was at work. On December 5, 1996, while speaking at the American Enterprise Institute, Greenspan asked…

“How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?”

“We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability,” continued Greenspan. “But we should not underestimate or become complacent about the complexity of the interactions of the asset markets and the economy. Thus, evaluating shifts in balance sheets, generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

Despite Greenspan’s concerns of escalating stock prices on December 5, 1996, he continued to pump money into the financial system as the Dow rocket from 6,437 on the day of his speech to a peak of 11,722 on January 14, 2000.

Passing the Mess

After the stock market bust in 2000-02, where the Dow fell nearly 40 percent, Greenspan again pumped money into the economy. This time the money found its way not only into the stock market, but into real estate, oil and gold prices. Then, again, following the 2008-09 crackup, the Fed was at it again.

This time, however, it was Bernanke at the controls…burdened with cleaning up Greenspan’s mess. But to do so, Bernanke had to behave like Greenspan on steroids. He’s added $2.25 trillion dollars to the Fed’s balance sheet and is currently inflating at a rate of over $1 trillion per year.

Just the thought of such heavy handed Fed intervention would’ve caused Greenspan to soil his pantaloons if he’d still been manning the monetary levers. Fortunately, for him, and his pants, he’s not. Yet, like Greenspan before him, Bernanke will pass his mess – an even larger mess – on to a new Fed Chairman come the end of January 2014.

At this point the new Fed Chairman will likely be current Vice Chair Janet Yellen. From what we gather, she wants even softer money than Bernanke. We can only imagine what “unconventional” tactics she’ll put into practice to keep from upsetting the apple cart.

Did you hear depositors in Cyprus are being forced to pay a “stability levy?” We hope this sort of outright theft never makes its way to the United States. But if things get desperate enough, anything could happen.

On Price Distortions and Landmines

In the meantime, will Bernanke be able to postpone another stock market crash until after he steps down?

The answer may depend on if Greenspan’s recent claim that the rise in stock market prices is not the result of irrational exuberance is true. Bernanke, too, may be helped by the fact that a good stock market mania can run up much further and last far longer than any man of sound mind and honest intentions could ever imagine. We’re confident it will all be revealed in due time.

For now, however, one thing is certain. Bernanke’s going to give it all he’s got to keep things inflated while he’s in office. You can count on it.

The days of Greenspan’s initial irrational exuberance remark are long gone. Considering the impacts of balance sheet changes and asset prices is no longer an integral part of monetary policy, if it ever were. The role of the Fed, at the moment, is to inflate the balance sheet and promote rising asset prices indefinitely.

Yet, no matter how much they inflate, prices cannot rise forever. They eventually crack…and crash. That’s when the absurdities of the Fed generated price distortions become fully apparent. There are plenty of landmines in place before you. Ten Year Treasuries yielding 1.96 percent is one example. Dow approaching 14,500, with 70 percent of stocks purchased on margin, is another.

If you can believe it, things will likely distort further before they correct. We suspect it will be breathtakingly spectacular while it lasts.